Alternative Risk Transfer WileyFinanceSeries AlternativeRiskTransfer:IntegratedRiskManagementthroughInsurance,ReinsuranceandtheCapitalMarkets ErikBanks ACurrencyOptionsPrimer ShaniShamah NewRiskMeasuresinInvestmentandRegulation GiorgioSzego¨(Editor) ModellingPricesinCompetitiveElectricityMarkets DerekBunn Inflation-IndexedSecurities:Bonds,SwapsandOtherDerivatives,2ndEdition MarkDeacon,AndrewDerryandDariushMirfendereski EuropeanFixedIncomeMarkets:Money,BondandInterestRates JonathanBatten,ThomasFetherstonandPeterSzilagyi(Editors) GlobalSecuritisationandCDOs JohnDeacon AppliedQuantitativeMethodsforTradingandInvestment ChristianL.Dunis,JasonLawsandPatrickNa¨ım(Editors) CountryRiskAssessment:AGuidetoGlobalInvestmentStrategy MichelHenryBouchet,EphraimClarkandBertrandGroslambert CreditDerivativesPricingModels:Models,PricingandImplementation PhilippJ.Scho¨nbucher HedgeFunds:AResourceforInvestors SimoneBorla AForeignExchangePrimer ShaniShamah TheSimpleRules:RevisitingtheArtofFinancialRiskManagement ErikBanks OptionTheory PeterJames Risk-adjustedLendingConditions WernerRosenberger MeasuringMarketRisk KevinDowd AnIntroductiontoMarketRiskManagement KevinDowd BehaviouralFinance JamesMontier AssetManagement:EquitiesDemystified ShantaAcharya AnIntroductiontoCapitalMarkets:Products,Strategies,Participants AndrewM.Chisholm HedgeFunds:MythsandLimits Franc¸ois-SergeLhabitant TheManager’sConciseGuidetoRisk JihadS.Nader SecuritiesOperations:AGuidetoTradeandPositionManagement MichaelSimmons Modeling,MeasuringandHedgingOperationalRisk MarceloCruz MonteCarloMethodsinFinance PeterJa¨ckel BuildingandUsingDynamicInterestRateModels KenKortanekandVladimirMedvedev StructuredEquityDerivatives:TheDefinitiveGuidetoExoticOptionsandStructuredNotes HarryKat AdvancedModellinginFinanceUsingExcelandVBA MaryJacksonandMikeStaunton OperationalRisk:MeasurementandModelling JackKing InterestRateModelling JessicaJamesandNickWebber Alternative Risk Transfer Integrated Risk Management through Insurance, Reinsurance, and the Capital Markets Erik Banks Copyright(cid:1)C 2004 JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester, WestSussexPO198SQ,England Telephone (+44)1243779777 Email(forordersandcustomerserviceenquiries):[email protected] VisitourHomePageonwww.wileyeurope.comorwww.wiley.com AllRightsReserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem ortransmittedinanyformorbyanymeans,electronic,mechanical,photocopying,recording, scanningorotherwise,exceptunderthetermsoftheCopyright,DesignsandPatentsAct1988 orunderthetermsofalicenceissuedbytheCopyrightLicensingAgencyLtd,90Tottenham CourtRoad,LondonW1T4LP,UK,withoutthepermissioninwritingofthePublisher. 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Contents Acknowledgements ix Biography xi PARTI: RISKANDTHEARTMARKET 1 1 OverviewofRiskManagement 3 1.1 Riskandreturn 3 1.2 Activeriskmanagement 5 1.2.1 Riskmanagementprocesses 6 1.2.2 Riskmanagementtechniques 7 1.2.3 Generalriskmanagementconsiderations 10 1.3 Riskconcepts 12 1.3.1 Expectedvalueandvariance 12 1.3.2 Riskaversion 14 1.3.3 Risktransferandtheinsurancemechanism 16 1.3.4 Diversificationandriskpooling 17 1.3.5 Hedging 20 1.3.6 Moralhazard,adverseselectionandbasisrisk 21 1.3.7 Non-insurancetransfers 22 1.4 Outlineofthebook 22 2 RiskManagementDrivers:TheoreticalMotivations,Benefits,andCosts 25 2.1 Maximizingenterprisevalue 25 2.2 Thedecisionframework 29 2.2.1 Replacementandabandonment 31 2.2.2 Costsandbenefitsoflosscontrol 31 2.2.3 Costsandbenefitsoflossfinancing 32 2.2.4 Costsandbenefitsofriskreduction 35 2.3 Copingwithmarketcycles 35 2.3.1 Insurancepricing 35 2.3.2 Hardversussoftmarkets 37 2.4 Accessingnewriskcapacity 42 2.5 Diversifyingthecreditriskofintermediaries 43 vi Contents 2.6 Managingenterpriserisksintelligently 44 2.7 Reducingtaxes 45 2.8 Overcomingregulatorybarriers 46 2.9 Capitalizingonderegulation 47 3 TheARTMarketanditsParticipants 49 3.1 AdefinitionofART 49 3.2 OriginsandbackgroundofART 51 3.3 Marketparticipants 52 3.3.1 Insurersandreinsurers 53 3.3.2 Investment,commercial,anduniversalbanks 55 3.3.3 Corporateend-users 56 3.3.4 Investors/capitalproviders 57 3.3.5 Insuranceagentsandbrokers 57 3.4 Productandmarketconvergence 58 PARTII: INSURANCEANDREINSURANCE 61 4 PrimaryInsurance/ReinsuranceContracts 63 4.1 Insuranceconcepts 63 4.2 Insuranceandlossfinancing 64 4.3 Primaryinsurancecontracts 65 4.3.1 Maximumrisktransfercontracts 65 4.3.2 Minimalrisktransfercontracts 66 4.3.3 Layeredinsurancecoverage 76 4.4 Reinsuranceandretrocessioncontracts 78 4.4.1 Facultativeandtreatyreinsurance 81 4.4.2 Quotashare,surplusshare,excessofloss,andreinsurancepools 81 4.4.3 Finitereinsurance 86 5 Captives 89 5.1 Usingcaptivestoretainrisks 89 5.1.1 Backgroundandfunction 89 5.1.2 Benefitsandcosts 91 5.2 Formsofcaptives 94 5.2.1 Purecaptives 94 5.2.2 Sistercaptives 95 5.2.3 Groupcaptives 95 5.2.4 Rent-a-captivesandprotectedcellcompanies 96 5.2.5 Riskretentiongroups 99 5.3 Taxconsequences 100 6 Multi-riskProducts 103 6.1 Multipleperilproducts 103 6.2 Multipletriggerproducts 106 Contents vii PARTIII: CAPITALMARKETS 113 7 CapitalMarketsIssuesandSecuritization 115 7.1 Overviewofsecuritization 115 7.2 Insurance-linkedsecurities 116 7.2.1 Overview 116 7.2.2 Costsandbenefits 118 7.3 Structuralfeatures 119 7.3.1 Issuingvehicles 119 7.3.2 Triggers 121 7.3.3 Tranches 123 7.4 Catastrophebonds 124 7.4.1 Hurricane 124 7.4.2 Earthquake 127 7.4.3 Windstorm 129 7.4.4 MultiplecatperilILSandperilbytrancheILS 129 7.4.5 Bond/derivativevariations 130 7.5 Otherinsurance-linkedsecurities 131 8 ContingentCapitalStructures 135 8.1 Creatingpost-lossfinancingproducts 135 8.2 Contingentdebt 139 8.2.1 Committedcapitalfacilities 139 8.2.2 Contingentsurplusnotes 140 8.2.3 Contingencyloans 141 8.2.4 Financialguarantees 142 8.3 Contingentequity 142 8.3.1 Lossequityputs 143 8.3.2 Putprotectedequity 146 9 InsuranceDerivatives 149 9.1 DerivativesandART 149 9.2 Generalcharacteristicsofderivatives 150 9.3 Exchange-tradedinsurancederivatives 156 9.3.1 Exchange-tradedcatastrophederivatives 156 9.3.2 Exchange-tradedtemperaturederivatives 157 9.4 OTCinsurancederivatives 162 9.4.1 Catastrophereinsuranceswaps 162 9.4.2 Purecatastropheswaps 164 9.4.3 Temperaturederivatives 164 9.4.4 Otherweatherderivatives 166 9.4.5 Creditderivatives 167 9.5 Bermudatransformersandcapitalmarketssubsidiaries 168 viii Contents PARTIV: ARTOFTHEFUTURE 171 10 EnterpriseRiskManagement 173 10.1 Combiningrisks 173 10.1.1 Theenterpriseriskmanagementconcept 173 10.1.2 Costsandbenefits 177 10.2 Developinganenterpriseriskmanagementprogram 179 10.2.1 Strategicandgovernanceconsiderations 180 10.2.2 Programblueprint 182 10.2.3 Programcosts 186 10.3 End-userdemand 188 11 ProspectsforGrowth 193 11.1 Driversofgrowth 193 11.2 Barrierstogrowth 194 11.3 Marketsegments 196 11.3.1 Finitestructures 196 11.3.2 Captives 197 11.3.3 Multi-riskproducts 197 11.3.4 Capitalmarketsissues 198 11.3.5 Contingentcapital 198 11.3.6 Insurancederivatives 199 11.3.7 Enterpriseriskmanagement 199 11.4 End-userprofiles 201 11.5 Futureconvergence 202 Glossary 205 SelectedReferences 221 Index 223 Acknowledgements Iwouldliketoexpressmygratitudetovariousindividualsfortheirhelpinmakingthisproject cometofruition.Specifically,greatthanksareduetoSamanthaWhittaker,publishingeditorat JohnWiley&Sons,forhersupportonthis,andvariousother,writingprojects.Thanksgoalso toPatriciaMorrison,publishingeditor,andCaroleMillett,editorialassistant,forhelpalong theway.ThanksalsogotoSamanthaHartley,productioneditor,forherhelpincoordinating productionofthebook. Iwouldalsoliketoacknowledgethevaluableassistanceprovidedbynumerousindividuals from various organizations, including the Insurance Services Office, Insurance Information Institute, XL Capital, and Merrill Lynch. They provided important input and information as theprojectdeveloped. And,mostofall,mythankstoMilena. E.Banks Redding,CT 2003